[security analysis and investment management]

STOCK MARKET INDEX

INTRODUCTION

Stock Market is a place where the stocks of a listed company are traded. A single
figure that sums up the overall performance of the market on a daily basis is the
Stock Index. A good Stock Index captures the movement of the well diversified
and highly liquid stocks. For a lay man it is the pulse rate of the economy. Index
movements reflect the changing expectations of the stock market about future
dividends of the corporate sector. The index is calculated by finding the weighted
average of the prices of the most actively traded companies in the market, where
the weights are generally in proportion to the market capitalization of the company.

A stock market index is a method of measuring a section of the stock market. An

stock market index (or just “index) is a number that measures the relative value of
a group of stocks. As the stocks in this group change value, the index also changes
value. If an index goes up by 1% then that means the total value of the securities
which make up the index have gone up by 1% in value.

Types of Indexes :

Stock market indices may be classed in many ways.

 World or Global Market Index: It includes (typically large) companies

without regard for where they are domiciled or traded.

EXAMPLE : MSCI World and S&P Global 100.

SAMRITI GOEL

MBA LECTURER
 [security analysis and investment management]

 Broad-Market Index: This consists of all the large, liquid stocks of the
country and becomes the benchmark for the entire capital market of the
country.
EXAMPLE : S&P CNX 500.
 Specialized Index: We can either have Industry or Sector specific Index for
any particular sector of the economy which then serves as the benchmark for
that particular industry or we can have an index for the highly liquid stocks.
EXAMPLE : S&P Banking Index S&P CNX Nifty, Morgan Stanley
Biotech Index.

METHODS

 Price Weighted: The weights assigned are proportional to the stock prices.
EXAMPLE : Dow Jones Industrial Average, Amex Major Market Index.
 Market Capitalization Weighted: The equity price is weighted by the
market capitalization of the company. Hence each constituent stock in the
index affects the index value in proportion to the market value of all
outstanding shares.
(Current market capitalization)
Index = ---------------------------------------- x Base Value
(Base Market Capitalization)
Where:
CMS = Sum of (current market price * outstanding shares) of all securities in the
index
BMS = Sum of (market price * issue size) of all securities as on base date.
EXAMPLE : Hang Seng Index.

SAMRITI GOEL

MBA LECTURER
 [security analysis and investment management]

 Equal Weighted: The weights are equal and assigned irrespective of both
market capitalization or price Index. The relevant index body makes clear,
researched and publicly documented rules for this purpose. These rules are
applied regularly, to obtain changes to the index set. However, it is ensured
that the value of the index does not change significantly after the revision of
the index set

Determinants of a Stock Index

Following parameters should be taken into picture before one constructs a stock
index:
 Liquidity – Liquidity of stocks as measured by the “impact cost” criterion
which determines the cost faced when actually trading the index. For
example if the current market price of a stock is Rs 200 and a trader
purchases it at Rs 202 (due to involved transaction costs) then the market
impact cost is 1% and the stock is considered highly liquid for lower impact
cost.
 Diversification – Diversification, by putting stocks of various sectors that
reflect the economy, is used to cancel out stock noise which is essentially
the individual stock fluctuations and to reduce investor’s risks. An index
must thus have a balanced representation of all sectors.
 Optimum size - More stocks lead to greater diversification but the limiting
factor is the size of the index. Increasing number of stocks in an index from
10 to say 30 gives a sharp reduction in risks but increasing the number
beyond a point does very little in risk reduction. Further it might lead to
addition of illiquid stocks.
For example, the optimal size for BSE Sensex is 30.

SAMRITI GOEL

MBA LECTURER
 [security analysis and investment management]

 Market Capitalization: The index should include primarily the stocks of

companies that have significant market capitalization with respect to the
index such that any major change in the price of the stock is reflected in the
index.
 Averaging - Every stock primarily moves for two reasons: The news about
the company and the news about the country. An ideal index is affected
only by the latter, that is the news of the economy and the effect of the
former is knocked out by proper averaging.

SOME INDEX
 BSE Sensex: Bombay Stock Exchange Sensitive Index. A value-weighted
stock market index, which tracks the performance of the 30 largest stocks
on the Bombay Stock Exchange. The 30 stocks are chosen at random times,
whenever the market has significantly changed enough to warrant the
changes, and are chosen by the value of their free float shares. Although the
index only tracks a very small percentage of the total stocks traded on the
BSE, the index typically comprises about one fifth of the market
capitalization of the entire stock exchange.

 S&P CNX NIFTY : The Standard & Poor's CRISIL NSE Index 50 or S&P
CNX Nifty nicknamed Nifty 50 or simply Nifty (NSE: ^NSEI), is the
leading index for large companies on the National Stock Exchange of India.
The Nifty is a well diversified 50 stock index accounting for 21 sectors of
the economy. It is used for a variety of purposes such as benchmarking fund
portfolios, index based derivatives and index funds. It is backed by solid

SAMRITI GOEL

MBA LECTURER
 [security analysis and investment management]

economic research and three extremely respected organizations (NSE,

CRISIL and S&P).
USES OF STOCK INDEX
 The Index finds uses in various fields starting from economic research to
helping investors choose appropriate portfolio for investment.
 Since the Index is an indicator of the overall mood of the investors in the
secondary market, it helps a company to answer questions like is it the right
time to take out an IPO, how to price the issue, etc.
 It acts as a signal to the government of the ‘feel good’ factor prevailing in
the economy.

LIMITATIONS OF STOCK INDEX

However, the market index is a double edged sword.
 Index is influenced by expectations of the future performance of the
stocks, it leads to a self fulfilling prophecy. Suppose an investor thinks that
the stock of the company is going to go down and this feeling prevails
across the market then everyone would want to get out of the company’s
stock. This will automatically lead to the stock prices crashing.
 The Stock Index can often also act as a trigger to herd mentality. Any
downturn in the market would be reinforced by the collective action of the
investors to hedge against any losses and get out of the market. This would
further depress the market.

SAMRITI GOEL

MBA LECTURER